10 Externalities

Externalities Externality The uncompensated impact of one person’s actions on the well-being of a bystander Negative externality Impact on the bystander is adverse Positive externality Impact on the bystander is beneficial

Externalities A more technical definition A cost that is suffered by a third party as a result of an economic transaction. In a transaction, the producer and consumer are the first and second parties, and third parties include any individual, organization, property owner, or resource that is indirectly affected by the production or consumption of the good by first/second parties.

Externalities and Market Inefficiency Cause markets to allocate resources inefficiently Welfare economics: a recap Demand curve – value to consumers Prices they are willing to pay Supply curve – cost to suppliers Equilibrium quantity and price Efficient Maximizes sum of producer & consumer surplus Without externalities present

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Why Is There Pollution? Pollution is a by-product of the production process Treated as a zero-priced input Dispose of waste for free Otherwise have to purchase abatement equipment Since price = 0 => consume to the point: MV = 0 However MC ≠ 0 So have a deadweight loss due to MV < MC Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Negative Externality Marginal Private Costs < Marginal Social Costs Ideal Actual Pi Pa Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Economics and Pollution Control The Two Big Questions What is the optimal level of pollution? How should it be allocated among its sources (firms)? Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

What Do We Need for Efficiency? Economic efficiency requires Minimize the costs of Damages caused by pollution Costs of reducing pollution At the margin (or at the optimum) Marginal (additional) costs of reducing pollution (pollution abatement costs) = marginal damages caused by incremental change in emissions Alternatively Maximize the benefits (derived from goods produced) While minimizing abatement and damage costs Yields same solution Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Determining the Optimal Amount of Pollution Tax Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Negative Externalities – A Graph A Cost Which is Incurred by Society That Should Be Accounted For But those in the Market (1st and 2nd Parties) Don’t Have to Pay For It

Market Failure Negative Externality – Not Accounted For in the Market’s Pricing/Costing of the Good Creates Deadweight Loss – Inefficient Use of Resources

Increased Health Care Costs Harvard Study: Coal Costs America $330-500 Billion Annually A Harvard University study published on Feb 17, 2011, has determined that the true costs of using coal to generate electricity in America are between $330 and $500 billion dollars annually. The study, "Mining Coal, Mounting Costs -- The Life Cycle Consequences of Coal" by the Harvard Medical School's Center for Health and the Global Environment examines the costs for so-called "cheap coal" that don't show up on the monthly electric bill: the so-called "externalities" or hidden costs.

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Externalities and Market Inefficiency Negative externalities - Pollution Cost to society (of producing electricity from coal) Larger than the cost to the electric utilities Does not include damage from acid rain Social cost - supply Private costs of the producers Plus the costs to those bystanders affected adversely by the negative externality Social cost curve – above the supply curve (private costs)

Pollution and the social optimum 2 Pollution and the social optimum Price of Electricity Social cost (private cost and external cost) External Cost Supply (private cost) Demand (private value) Optimum QOPTIMUM Equilibrium QMARKET Megawattsof Electricity In the presence of a negative externality, such as pollution, the social cost of the good exceeds the private cost. The optimal quantity, QOPTIMUM, is therefore smaller than the equilibrium quantity, QMARKET.

Externalities and Market Inefficiency Negative externalities Markets - produce a larger quantity than is socially desirable Positive externalities Markets - produce a smaller quantity than is socially desirable Government: “internalize” the externality Taxing goods that have negative externalities Subsidizing goods that have positive externalities

Public Policies Toward Externalities Command-and-control policies: regulation Regulate behavior directly Making certain behaviors either required or forbidden Cannot eradicate pollution Environmental Protection Agency (EPA) Develop and enforce regulations Protecting the environment Dictates maximum level of pollution Requires that firms adopt a particular technology to reduce emissions

Public Policies Toward Externalities Market-based policies Provide incentives Private decision makers - choose to solve the problem on their own 1. Corrective taxes and subsidies Corrective tax Induce private decision makers to take account of the social costs that arise from a negative externality Places a price on the right to pollute Reduce pollution at a lower cost to society

Why is gasoline taxed so heavily? The gas tax = corrective tax Three negative externalities Congestion Accidents Pollution Doesn’t cause deadweight losses Makes the economy more efficient Less traffic congestion, safer roads, and cleaner environment

Why is gasoline taxed so heavily? How high should the tax on gasoline be? Most European countries Gasoline taxes - much higher than those in the U.S. 2007 study, Journal of Economic Literature Optimal corrective tax on gasoline was $2.10 per gallon Actual tax in the United States: 40 cents Tax revenue from a gasoline tax Lower taxes that distort incentives and cause deadweight losses Some government regulations Production of fuel-efficient cars – unnecessary

Public Policies Toward Externalities Market-based policies 2. Tradable pollution permits Voluntary transfer of the right to pollute from one firm to another New scarce resource: pollution permits Market to trade permits Firm’s willingness to pay Depend on its cost of reducing pollution

Public Policies Toward Externalities 2. Tradable pollution permits Advantage of free market for pollution permits Initial allocation of pollution permits Doesn't matter Firms - reduce pollution at a low cost Sell whatever permits they get Firms - reduce pollution only at a high cost Buy whatever permits they need Efficient final allocation

Controlling Pollution The following table shows the marginal costs for each of four firms (A, B, C, and D) to eliminate units of pollution from their production processes. For example, for Firm A to eliminate one unit of pollution, it would cost $54, and for Firm A to eliminate a second unit of pollution it would cost an additional $67.   Firm Unit to be eliminated A B C D First unit 54 57 62 Second unit 67 68 66 73 Third unit 82 86 91 Fourth unit 107 108 111

Three Policy Approaches Suppose that the government determines that the optimal level of pollution is 8 total units for the entire industry A) If the government requires each firm to reduce its current level of pollution (4 units) by 50% (2 units each), what would be the total cost of the industry (and to society) of reducing pollution? B) What per-unit tax on emissions could the government set to reduce pollution by 50%? C) Suppose that the government issues 2 tradable (can be sold to another firm) to each firm. The firm can either use it to reduce pollution by 50% (2 units) or can resell the permit to another firm. But then will have to pay the marginal cost of treating the unit for which the permit would have been used. What would be the market price for the permit and how many would be sold?

Public Policies Toward Externalities Reducing pollution using pollution permits or corrective taxes Firms pay for their pollution Corrective taxes - to the government Pollution permits, - buy permits Internalize the externality of pollution

The equivalence of corrective taxes & pollution permits 4 The equivalence of corrective taxes & pollution permits (a) Corrective tax (b) Pollution permits Price of pollution Price of pollution 1. A corrective tax sets the price of pollution . . . Q Supply of pollution permits Demand for pollution rights Demand for pollution rights 1. Pollution permits set the quantity of pollution . . . P Corrective tax P Q 2. . . . which, together with the demand curve, determines the price of pollution. 2. . . . which, together with the demand curve, determines the quantity of pollution. Quantity of pollution Quantity of pollution In panel (a), the EPA sets a price on pollution by levying a corrective tax, and the demand curve determines the quantity of pollution. In panel (b), the EPA limits the quantity of pollution by limiting the number of pollution permits, and the demand curve determines the price of pollution. The price and quantity of pollution are the same in the two cases.

Public Policies Toward Externalities Objections to the economic analysis of pollution “We cannot give anyone the option of polluting for a fee.” - former Senator Edmund Muskie People face trade-offs Eliminating all pollution is impossible Clean water and clean air – opportunity cost Lower standard of living

Public Policies Toward Externalities Clean environment - is a normal good Positive income elasticity Rich countries can afford a cleaner environment More rigorous environmental protection Clean air and clean water - law of demand The lower the price of environmental protection The more the public will want Economic approach Pollution permits and corrective taxes Reduces the cost of environmental protection Increase demand for a clean environment

Private Solutions to Externalities The Coase theorem If private parties can bargain without cost over the allocation of resources They can solve the problem of externalities on their own Private economic actors Can solve the problem of externalities among themselves Whatever the initial distribution of rights Interested parties - reach a bargain: Everyone is better off & Outcome is efficient

Private Solutions to Externalities Why private solutions do not always work High transaction costs Costs that parties incur in the process of agreeing to and following through on a bargain Bargaining simply breaks down Large number of interested parties

Technology spillovers, industrial policy, and patent protection Technology spillover = Positive externality Impact of one firm’s research and production efforts on other firms’ access to technological advance Government: internalize the externality Subsidy = value of the technology spillover Industrial policy Government intervention in the economy that aims to promote technology-enhancing industries Patent law Protect the rights of inventors by giving them exclusive use of their inventions for a period of time

Market Failure Market Failure Sources When the free market may not provide economically efficient (ideal) outcome Sources Too little competition Monopoly/Cartels Too little output/total surplus (deadweight loss) Goods produced at too high a cost Asymmetric Information Financial Markets (insider trading – Facebook IPO) Externalities (positive and negative)